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Carmel Epstein
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  • 4 Myths Machining The Bull Market 0 comments
    Jun 10, 2013 10:31 AM | about stocks: TMV, TMF, VXX

    The following commentary is entirely my analysis and viewpoint and can, at best, be described as speculation towards what is present in the thought processes of the agents of action in the associated asset classes present in the market. I establish some precedence and only a thought process. I include some sources, and the rest can be easily discovered from reputable sources (marketwatch, Bloomberg, etc.) using no more than a google search. If any questions remain or sources cannot be located, feel free to email me or post in the commentary and I will address your questions promptly and forward any research materials appropriately. Please note: there is a disclaimer regarding my current position in the market, though it is not subject to change, it pertains to some of the counter-arguments I provide in this analysis.

    Bonds will act on the Basis of the Fed's Activity

    We keep hearing rumors that bond markets are falling because of speculation that the fed will cut back its buying operations dubbed QE. This seems a little bit obtuse given other events that have transpired in the market. In other words, I think the media is missing the much more important message that confidence is waning.

    While the Fed is a very serious player in the market and is normally able to influence markets, its hegemony as the only market player is waning. Let's look back:

    In December of last year the Fed declared its QE "to Infinity and Beyond" the justification of which was to increase risk premium, as Beta values consolidated down, due to '08 volatility data coming out, as status quo data going in (remember it's a moving average; oh and for those in a euphoric bull market coma for the last few years, we experienced massive volatility back in '08). The increased return should provide the "escape velocity" necessary to get us back to growth. To break this down simply, force investors to hold risk bearing securities because the paltry returns from the risk free rate don't incentivize parking capital there.

    The grave problem with this perspective is that the market did not react the way it was expected to. The fed said, "we buy" and the market responded, "Benny Boy, we see your QE and we raise you the force of Gravity". For the first time, the viability and hegemony of the FOMC was questioned by the rest of the market. This has never happened before. This may mean there is waning confidence that the Fed can control rates and keep them down.

    Remember, the market determines rates. The fed can influence them, but they can't control them. Now while the Fed is acting to buy all the new securities coming out, that is a mere fraction of the paper available. The fed's miscalculation was that they believed that the market would never question them (despite overwhelming evidence that its counterparts in Europe and Asia have made similar mistakes for the last 20 years). The market, it seems, decided that rates were too low already. They already weren't willing to accept it. Another case of buy the rumor, sell the fact. The fed made the mistake of giving active investors an asymmetric bet. For those paying attention, this is the warning we've been hearing from the likes of Stanley Drukenmiller, Michael Stienhardt, (insert here other legendary investors of Christmas past) etc.

    While Ben Bernanke got a shellacking from congress during his testimony this past month, he never clearly established what the FOMC intends to do. He established they may raise their buying activity as well. I have to credit him with at least being vague on this level. Markets don't like absolute statements by central bankers. That strategic ambiguity on his part makes him the strongest of his counterparts of recent history, but it still isn't enough. Let's look at what transpired before and after that little testimony: (1) 2 days before the testimony, the fed announced they intended to buy an additional $1.8 Billion of long term treasuries and the market was barely phased. (2) 1 day before hand, the various members of the fed started voicing their opinions and the bond market rose a bit more. However, it was nothing compared to the blood-letting that would face bond holders after the testimony.

    In conclusion, between the Fed claiming it's acting, and logically (fundamentally speaking) mitigating the risk of the securities, the market has voted no confidence. The Fed has claimed there is no bubble, the bond market sold off. The Fed said they're buying and the market responded by selling. The fed threw everything in and the kitchen sink most recently to inspire confidence, and the market is selling bonds on every uptick. (actually that's optimistic… it normally doesn't wait for an uptick)

    The risk free nature of bonds as an investment

    There are many parties that can be blamed for chaos in the markets in recent past, but none more-so than academia. They build models and convince the Nobel Committee that they are worthy of a prize bearing the image of the bigot who created dynamite. History has its irony as the models that bear his name threaten the markets far more than explosives ever have. (For further reading, look to The Black Swan by: Nassim Taleb; his sense of humor is just a little less dry than my own.)

    When William Forsythe Sharpe came up with the first metric for determining risk-adjusted returns (dubbed the Sharpe Ratio), he based it on the idea that long term U.S. government bonds are the risk free rate of return. It's a little humorous that giving a person academic training and sending him to wall street leads him to believe that there is such a thing as "risk-free return", when anyone on mainstreet will iterate the old adage "cash is king".

    The model also uses time series data of 5 years of month end prices. This probably is why the active players today seem to have amnesia when recalling the chaos that hit bond markets back on the tail end of '93. (for further reading see 'Hurricane Greenspan' in Sebastian Mallaby's More Money than God). The problem back in '93 really broke down to an unregulated aspect of the market due to shadow banking where Private Equity groups and Hedge Funds started playing the yield curve (they borrowed short term to lend long term). They overcrowded the market, so when Greenspan closed the discount window by raising short term rates by a mere 25 basis points, the sell-off in long term government treasuries collapsed, raising rates a full 100 basis points. The discount window has been open since 2008, so there isn't reason to believe that banks have been incentivized to do something different.

    Further, while efficient market theorists have been forced to climb back to the shadows from which they came, Eugene Fama and Kenneth French published a very appropriate paper on active portfolio management returns. It concluded that after adjusting for the factors in the Carhart 4 factor model, and the AUM of the funds tracked, that returns were almost normally distributed. We know that markets aren't normally distributed (even though most models conveniently assume they are), so when they become normally distributed, we have a good basis for speculating that a market maybe overcrowded. Take a look at treasury etf returns for the past year. It's a little too close to normal for comfort. Crowded markets lack liquidity.

    In conclusion, the only risk free, is return free. The last thing that economists seem to have said that made any sense is that "there's no free lunch." However, it appears bond holders may be still counting on the theory of "greater fools".

    Market regulations and consolidation of interbank markets to exchanges make markets much more liquid and transparent.

    In the wake of 2008, it became politically correct to call for regulation to usurp banking protocols that resulted in tax-payer bailouts for the sociopathic 'drunk' wall street bankers, with their penchant for call girls and drug addictions. Low and behold, though no one really got more than a scolding, a regulation did come out of it everyone refers to as Dodd-Frank. Since this document became signed, sealed, and written into law in 2010, it created deadlines requiring banks to disclose to regulatory bodies what they are holding in terms of credit derivatives. The security at hand here is an interest rate swap. Effectively it's an insurance agreement against rising rates (the simplest version 'vanilla'). There are a few problems with this that generate massive counterparty risk.

    (1) Similar to credit default swaps that hi-jacked the ABS market back in '07, there is very little if not any money put up front. (look to public commentary by active insiders).

    (2) Worse than '07 the counterparties are less recognized today than they were then. Debt markets are very closely associated with currency markets (for reasons why, see Soros' The Alchemy of Finance). Currency markets are international and unregulated. There is no international regulatory body to affirm whether or not the floating rate recipients can make the payout on the floating rates. While the Eurozone passed legislation requiring limits on these agreements, they conveniently left an exemption for parties involved in market making. (See the FAQ on the regulation for quick answers on this). Being as rates rise when there is confidence lacking on a nations ability to make payments on their debts, I wouldn't be surprised if the market making involves buying credit default swaps and selling interest rate swaps (where the proceeds of one credit default swap would "theoretically" be enough to pay off multiple interest rate swaps.)

    (3) This market is excessively massive. According to data surveyed by the bank of International Settlements, the surveyed banks report that the number of these swaps (in notational value) exceed that of their existence back in 2007 when markets were ripe with leverage based on Value at Risk calculations. This market isn't too significant, after all, it only amounts to $339 Trillion. There isn't anywhere near that amount of money in the world, it's seeming that there are parties insuring contracts they must have sold others. If one party defaults, there could be massive contagion.

    (4) The first filing deadline for the big parties in March caused a massive drop in bonds prior to the filing deadline. Bonds rose after that, but there may be reason to believe that the real risk was not revealed by those filings. Since banks started cutting compensations, the real talent has spun off from the banks to small boutique prop shops and hedge funds, their deadline is today. Unlike the big banks, there is little by which recipients of the floating rate can hedge against their counter party risk (it is hard to get quoted for a credit default swap on a small proprietary firm.) If they fear this risk, bond holders may be selling now and pick up some later if the risk seems unfounded.

    (5) As volatility rises, the floating rate volatility premium increases. Even still, firms may not be willing to insure future securities, right when Wall Street comes to the realization they might need it.

    (6) Goldman Sachs, when bonds are at an all time high, is willing to offer floating rate bonds in the future. If Goldman is the gold standard, and they have so much faith in these contracts, what might the lesser talent believe?

    Prior to the '08 bubble, John Paulson made a killing buying Credit Default Swaps on the BBB rated MBS. At first he had a problem getting his hands on these securities, but then wall street created the ABX so he was able to buy almost to his heart's content. (See The Big Short) Wall Street market makers always claim that the existence of open exchanges like this make markets more transparent and thus more liquid. The basis of this is very shaky.

    How can a market agent trust that a market be liquid, when now all the players involved get the same exact information at exactly the same time. Markets crash when there is an absolute absence of buyers when everyone else is trying to sell. If available market information creates a massive disincentive to buy, and a massive incentive to sell, markets crash. For historical precedence, the crash of '87 happened when equity markets were perceived to be most liquid. The insurers seemed to provide this liquidity (via portfolio insurance), and the quants were spellbound as to how this perceived liquidity disappeared when the markets needed it the most. A similar platform advertising such transparency has been created most recently by several firms, the one that immediately comes to mind is the SDX. (Super-Derivatives)

    Equity and Debt markets are inversely associated.

    No one is bullish on bonds it seems. Even the contrarians aren't willing to touch them. Warren Buffet aspires to 'pity' bondholders. The famous value investor seems to think that this has little influence on equities. Risk premium contracts when either equities rise, risk free rates rise, or when volatility leads to harder discounting. Equities are at all time highs, bonds are falling, and volatility is being priced near all time lows. If bonds fall rather fast, that would increase volatility (as the volatility of the two markets are highly correlated as time series data would suggest) and capital flight out of the risk free rate doesn't necessarily incentivize risk taking.

    According to models readily available, the most important aspect of value investing is Price/Ratio. So why would Warren Buffet sell out of the best 'value buy' (according to that metric anyway), when he got such a sweet heart deal that no one else could get? (If you don't know what I'm referring to, check out his Bank of America deal. Then, articles about 13F's filed appropriately alienating them.) Could it be because of their holdings of treasuries. I don't know, but if I had to look at the timing, it would suggest as much. In July of last year, Warren Buffet expressed sincere doubt that the Fed had any more tools to grow this economy. In March, he expressed genuine concern, if not panic. Today he shows nothing short of Euphoria at the awe of this high flying bull market. If we look closer at Berkshire Hathaway's portfolio, he's holding the stock of a bunch of credit card companies. These companies have a lot more padding and can adjust rates much easier than regular banks can. Other living legends followed suit (Paulson and Soros)

    Then, we arrive at the case of other big institutional holders: Japan started faltering as one of the biggest holders of treasuries following Ben Bernanke's remarks and the yen started appreciating against the dollar. PIMCO's Bill Gross gives a "eulogy" for the bond bull market. The market responded in the following weeks with much more volatility than he may have anticipated, and now he's claiming that he still likes bonds. I'm not a psychiatrist, but it sounds like he's trumping the horn of his own portfolio. The man is brilliant beyond a doubt, but maybe he spoke before considering his funds' half a trillion in holdings of government securities?

    My concern however, is far more fundamental. We've been hearing much recently about American companies beating earnings estimates by 'cutting costs'. They apparently have copious vaults of cash that they should have no problem investing it. It's no secret that Investment banks are supposed to generate a significant proportion of their profits from brokering securities. So when the markets turned downward, they may have started brokering American companies a sort of insurance against a downturn in the economic cycle. What better than long term government treasuries? They are after all "risk free."

    So if these companies are having modest growth in revenues at best, where are their profits coming from? Might it be banking? These companies borrow short term to procure resources and finance operations. They engage in their normal activities, then, they invest their profits in Long term treasuries. If we take the noise out of the middle, what this seems to suggest is that corporations are borrowing short term to lend long term. If we can't trust banks to be good at banking, can we trust corporations involved in other sectors of the economy to be any better? Tech companies have had the least amount of revenue growth as a sector, yet many have exceeded earnings estimates. Then we find that the CFO's of these companies are receiving higher compensations than the CEO's. What does that implicate about the source of their earnings. At the very least, this brings to light the important question of what costs are really being cut? Are they due to an increase in efficiency or a decrease in financing costs.

    Numerous articles dated within the past year claim these firms have $5.2 Trillion in cash reserves, held in Treasuries. The S&P 500 has a market cap just over $14 Trillion. That, with an average price to book greater than 1. That means that at the very least almost half of their net assets are invested in this paper. Treasuries are not cash, they fluctuate at the whim of the market. We've heard many securities or combinations thereof considered as good as cash, only to find they weren't after all. We may be repeating the same mistake due to these simple myths manifesting again.

    Disclaimer: This is only commentary on the basis of my own speculation due to information that is publicly available. I'm not licensed to advise in any manner, nor do I seek to do so. The purpose of this commentary and analysis is solely for the purpose of shedding a different perspective on the prevailing themes present in the market today. If this article adds anything positive to the debate that helps spare an unnecessary loss of wealth than it shall have served its purpose.

    I'm currently positioned in options positions holding VIX, VXX, TMV, and TMF. All the expiration dates are from 1 - 3 months, and are distributed amongst multiple strike prices. I cannot, nor do I, recommend these instruments as an investment vehicle for others. I am not planning on initiating any new positions nor closing existing ones within 72 hours.

    If you have any questions about this article, feel free to email me at cepstei2@gmail.com

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